IntroductionEconomic models are always intended to simplify the real-world complex economic issues and provide efficient information to the users, and such role is taken by Capital Asset Pricing Model (CAPM) as well. The CAPM is the key theory in the stock market and industries; it is widely used by analysts, investors and corporations. In this essay I am going to discuss the recent developments about the CAPM, and refer to both advantages and disadvantages. Capital Asset Pricing Model

The initial development of the CAPM was building upon Markowitz’s idea, and the model was further developed by Sharpe, Treynor, Lintner, Mossion in 1960s. Basically, the Capital asset pricing model shows the theory of the relationship between risks and returns which state that the expected risk premium on any security equals its beta time the market risk premium. (Brealey/Myers/Marcus, 2009) In other word, the CAPM laid the basis for modelling the risk-return relationship, it is considered as the central theory that links risk and return for all assets and it is based on very strong assumptions.

The reasons of why the CAPM became so popular and has been widely used since it has been introduced to the market are not only due to the simple form and easy to understand, but also due to the wide range of applications. 1.Calculates the expect rate of return

The basic idea behind the model is that the investors expect a reward for both waiting and worrying, thus the CAPM has a simple interpretation, which are the expected rates of return required by investors rely on two things: •Compensation for the time value of money which indicates by the risk-free rates •A risk premium, which depends on beta and the market risk premium. The investors is rewarded with the risk premium for taking on the risk associated with the investment 2. Contribute to the asset classification and allocate resources Risk depends on exposure to macroeconomic events and can be measured as the...

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...CAPITALASSETPRICINGMODEL (CAPM) The capitalassetpricingmodel (CAPM) is an important model in finance theory. CAPM is a theory or model use to calculate the risk and expected return rate of an investment portfolio (normally refer to stocks or shares). All stocks have 2 risks: Systematic Risk (also called Market Risk which affect every stocks) and Unsystematic Risk (also called Specific or Unique Risk that only affects individual stocks). To diversify unsystematic risk, we selected and combined different stocks, which are negatively correlated with one another into one portfolio. In this way risk are eliminated greatly. See diagram below.
CAPM Equation The general formula used for CapitalAssetPricingModel is: re = rf + [ ß (rm - rf) ] where the components are as follows: re = Expected return rate of the investment portfolio rf = Risk free rate of return ß = Beta (correlation between the shares and the market) rm = Expected market return which also means: rm - rf = Market risk (systematic risk) ß (rm - rf) = Risk premium *Beta is overall risk value for investing in the stock market. The higher the beta, the more the risk.
CAPM Example Assume there is two Investment portfolio (stocks) or project - A & B. With the information given below, we can use CAPM to help us...

...also found on the balance sheet. The value was $3,494.5 million. Therefore, Joanna found Nike’s debt plus equity to be $4,791.4 million. Dividing the values for debt and equity each by $4,791.4 million gave Joanna the weights to be used in the WACC formula. Debt was weighted as 27% and equity as 73%.
Joanna then proceeded to calculate Nike’s costs of debt and equity. She found Nike’s cost of debt by dividing total interest expense, which was found on the income statement, by her previous calculation for debt. Nike’s total interest expense was $58.7 million, so their cost of debt was found to be 4.3%. Joanna used a tax rate of 38% in her calculations, making Nike’s cost of debt after tax to be 2.7%. Joanna decided to use the CAPM model in her calculation of Nike’s cost of equity. She used the risk-free rate of 5.74% on a 20-year Treasury bond, the geometric mean for market risk premium from 1929 to 1999 which was 5.9%, and Nike’s average beta from 1996 to 2001, which was 0.80 to make her calculations. Using these values, she obtained a cost of equity of 10.5%. Joanna then took the weights and costs of debt and equity that she found and calculated Nike’s WACC to be 8.4%.
Joanna made several errors in her calculation of Nike’s WACC. To begin, she used book values when finding Nike’s debt and equity rather than market values.
If markets are efficient, market values will equal present value of cash flows. Book values, on the other hand, represent...

...CAPM: THEORY, ADVANTAGES, AND DISADVANTAGES
THE CAPITALASSETPRICINGMODEL RELEVANT TO ACCA QUALIFICATION PAPER F9
Section F of the Study Guide for Paper F9 contains several references to the capitalassetpricingmodel (CAPM). This article is the last in a series of three, and looks at the theory, advantages, and disadvantages of the CAPM. The first article, published in the January 2008 issue of student accountant introduced the CAPM and its components, showed how the model can be used to estimate the cost of equity, and introduced the asset beta formula. The second article, published in the April 2008 issue, looked at applying the CAPM to calculate a project-specific discount rate to use in investment appraisal.
CAPM FORMULA The linear relationship between the return required on an investment (whether in stock market securities or in business operations) and its systematic risk is represented by the CAPM formula, which is given in the Paper F9 Formulae Sheet: E(ri) = Rf + βi(E(rm) - Rf) E(ri) = return required on financial asset i Rf = risk-free rate of return βi = beta value for financial asset i E(rm) = average return on the capital market The CAPM is an important area of financial management. In fact, it has even been suggested that finance only became ‘a fully-fledged, scientific...

...The second element of total risk is related to macroeconomic events that affect the prices of all securities and are reflected in broad market movements (ibid). Under the perfect capital markets, the assumptions for the Mean-Variance approach can be concluded as the following three points: first is the single-period model. Second is the preferences of the investors are merely depend on the mean and variance of payoffs, which means at a given mean, lower variance is preferred and with a given variance, a higher mean is preferred. Last but not least, the price-taking does not include taxes and transaction costs.
According to Cousins (n.d.), the CAPM draws conclusions from a variety of assumptions. Some are vital to its premise, others cause only minor changes if they are untrue. Since the early 1970s much research into the plausibility and effects of weakness in these assumptions has been conducted by academia. The assumptions that form the basis for the CAPM are:
* Investors in the capital market are risk averse and they always desire more return to less and they will avoid risk if all else is equal.
* There are no restrictions on the borrowing and lending of money at the risk-free rate of interest.
* All possible investments are traded in the market and are available to everyone, the assets are infinitely devisable, and there are no restrictions on short selling.
* The market is perfectly efficient...

... 2. Low competition
3. High demand
* Weakness: 1. High capital required
2. Slow product process
* Opportunity: 1. Highly required in military
2. Increase goodwill of the company
* Threat: 1. Limited business area
2. High product quality required(high responsibility for products)
3. Legal issues
Weighted Average Cost of Capital Analysis (WACC):
In this case, we use WACC as the required rate of return to calculate the company’s net present value. The CAPM theory is being used here to find the cost of equity and yield to maturity to be its cost of debt.
Cost Of Equity by CapitalAssetPricingModel (CAPM model):
Formula:
The risk free rate is 4%( 20-year Government of Canada spot rate), the marker risk premium is 5%, the Beta is 1.388 which we use regression to get it. (yellow highlight)
Then, we get the cost of equity is 0.04+1.388*0.05=0.1094
Cost Of Debt:
The maturity of bond is 10 years, the coupon rate is 6.77 cent per and current price is $98.56. Based on those, we get the yield to maturity is 6.98%, which also means the cost of debt is 6.98%
WACC:
formula: tax: 30%
The weight of debt is 40% and the weight of equity is 60%. The WACC =0.0698*(1-0.3)*0.4+0.1094*0.6=0.085184
The advantage and disadvantage of cost of equity by using CAPM:
The...

...CHAPTER 9
THE CAPITALASSETPRICINGMODEL
9.1 THE CAPITALASSETPRICINGMODEL
1. The CAPM and its Assumptions
The capitalassetpricingmodel (CAPM) is a set of predictions concerning equilibrium expected re¬turns on risky assets. Harry Markowitz laid down the foundation of modern portfolio man¬agement in 1952. The CAPM was developed 12 years later in articles by William Sharpe (1964), John Lintner (1965), and Jan Mossin (1966). The time for this gestation indicates that the leap from Markowitz's portfolio selection model to the CAPM is not trivial.
We summarize the simplifying assumptions that lead to the basic version of the CAPM in the following list. The trust of these assumptions is that we try to assure that individuals are as alike as possible, with the notable exceptions of initial wealth and risk aversion. We will see that conformity of investor behaviour vastly simplifies our analysis.
1. There are many investors, each with an endowment (wealth) that is small compared to the total endowment of all investors. Investors are price-takers, in that they act as though security prices are unaffected by their own trades. This is the usual perfect competition assumption of microeconomics.
2. All investors plan for one identical holding period. This behavior is...

...1. Dividend Growth ModelThe basic assumption in the Dividend Growth Model is that the dividend is expected to grow at a constant rate. That this growth rate will not change for the duration of the evaluated period. As a result, this may skew the resultant for companies that are experiencing rapid growth. The Dividend Growth Model is better suited for those stable companies that fit the model. Those that are growing quickly or that don't pay dividends do not fit the assumption parameters, and thus this model cannot be used. In this model, a company may not exceed the market growth rate.
In addition, since the dividend growth rate is expected to remain constant indefinitely, the other measures of performance within the company are also expected to maintain the same growth rate. If in the current state, the dividend rate is greater that earnings, in time this model will show a dividend payout greater than the earnings of the company. Conversely, if earnings are growing faster than dividends, the payout rate will converge towards zero.
In summary, the Dividend Growth Model works well for those companies growing at a rate equal to or lower than that of the economy and have an established and stable dividend payout.
In order to estimate the cost of equity using the Dividend Growth Model, we simply adjust the model's equation for estimating the price of a stock,...